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An Economics Education by Bitcoin – Part II

The first Bitcoin wallets were integrated with the distributed systems which talked to each other to reach a consensus on transactions which had taken place. This consensus is called the “block chain.” Each transaction is recorded in the block chain, showing whose authority was used to transfer that value in Bitcoins, and which new authority controls them. Being distributed rather than centrally-controlled, the nodes hear about transactions through the proverbial grapevine and then compare notes, following a predetermined algorithm to settle discrepancies. As more nodes come to a consensus about the validity of a transfer, it becomes more indelibly recorded in the block chain. Since the block chain contains the entire recorded history of every transfer that was ever made of every Bitcoin that ever existed, it continues to grow, so streamlined wallets have been designed which store Bitcoin codes, but which are dependent upon third-party “full” nodes for verifying and recording transfers. These are ideal for mobile devices with limited resources, but are not limited to such devices. The choice between utilizing a full or a streamlined wallet is the first of many decisions a Bitcoin market participant has to face.

Full nodes consume more storage space, and they verify and record transactions for and from the network, which consumes bandwidth and processing power. Allocating these resources to Bitcoin functions reduces the efficiency of a computer for other purposes, but it is not without reward. Processing Bitcoin transactions, i.e., “mining,” can generate fees for the systems performing that processing, so given an efficient enough computer and an inexpensive source of electricity, it’s possible to actually earn a profit by operating a full node. There’s also the added reliability of being at the same tier as the other core systems in the Bitcoin network, rather than being one tier down, dependent upon another core system. While I initially thought that the advantages of running a core system outweighed the costs, I came to realize that there is a lot of competition in the field of mining, and that my value-line desktop computer was not going to make me rich by processing transactions. Ultimately, I also didn’t want to allocate its limited resources to running a core node.

Having come to that realization, the next thing I realized was that I might not want my Bitcoins tied to a wallet on my desktop computer. I mean, hey, I’m going to want to spend them wherever I am, right? Maybe a mobile app for my cell phone would be a good choice – I’d always have it with me. This, however, is where another weakness came into view. What if I lose or break my cell phone? Losing a cell phone with a mobile Bitcoin wallet is not like losing a credit card. You can’t simply obtain a prompt replacement – in this regard, it’s more like losing a wallet full of cash. If someone doesn’t return the “wallet,” your Bitcoins are gone.

As an interesting aside, there is a hard limit to the number of Bitcoins which will ever come into existence, so if a wallet is lost – or even if just the password to the wallet is lost – it’s possible for the Bitcoins contained therein to become permanently inaccessible. Since such accidents do happen, this means that Bitcoins will actually become more scarce, and thus, will experience long-run increases in purchasing power, unlike fiat currencies which are printed incessantly, and eternally buy less.

Anyway, not wanting to experience such loss and attendant disappointment, I needed a way to back up my mobile-based wallet. If I kept a copy on my home computer, it and my cell phone could both perish in the same house fire so I ultimately decided that a Web-based solution was the best choice for me. I can access it from my smartphone, from my desktop PC, or from an Internet café wherever in the world I might find myself at any time. I trust a third-party to run a Bitcoin “core” installation, to perform backups, and to give me Web-based access to any number of Bitcoin wallets I might like to create. Some of the services they provide generate fees for them. In this regard, they’re something like a traditional bank account, holding your funds, executing transactions per your instructions, and possessing the ability to abscond with your money, but unlike a bank account, there is no FDIC insurance. Consequently, I’ve decided that this is a fine solution for storing small balances of Bitcoin, but I’ve made a mental note to reevaluate the risks should my balances become more significant.